Trevor Greetham: When will equities turn bearish?

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To date, 2017 has been good news for equity markets. But as indices continue to grind higher, nervous investors are increasingly on the lookout for the market trends that will bring the twist to this positive story.

Interest rates have lagged inflation since the financial crisis and the situation has worsened since the EU referendum, with the weak pound pushing inflation higher. As a result, cash returns have been negative in real terms each year since 2008 and its purchasing power has fallen by 20 per cent over this period. It has paid to stay invested.

Will interest rates continue to lag inflation? While the Bank of England is expected to reverse the emergency rate cut made following the referendum by the end of this year, it is unlikely this will signal the start of a sustained tightening cycle.

The Bank has highlighted the need to exercise caution when considering raising rates in light of the high levels of unsecured consumer debt in the UK. This, combined with ongoing Brexit uncertainty, should prevent rates from rising significantly in the near term. Cash will continue to burn holes in pockets.

Some investors cite the length of the current equity market cycle, which is already into its eighth year, as justification for turning bearish. However, it is the nature of stock markets to rise over time and the length of the current rally does not, alone, imply an impending correction. Bull markets do not die of old age.

As shown in the chart, there is a strong correlation between trends in unemployment and trends in stock markets: rising unemployment signals a recession and a fall in stock prices. However, we are currently seeing a strong downward trend in unemployment.

There is also little evidence of the excessive growth that led to the rate rises that ended the 1980s bull market, the excessive bullishness that triggered the sell-off that put paid to the 1990s dot-com bubble or the excessive financial leverage that sparked the banking crisis in 2008.

Growth is steady and there is no sign of the late-cycle surge in wages that leads central banks to raise interest rates meaningfully. Banks have significantly increased their capital buffers to satisfy tighter regulation since the financial crisis and, if anything, markets are tending towards excessive bearishness.

Contrary to most people’s expectations, the majority of portfolios increased in value after the UK voted to leave the EU, making 2016 the best year for multi-asset investors since 2009. A 15 per cent drop in the value of sterling boosted the value of overseas investments and the UK equity market, which sources 70 per cent of its earnings overseas.

As things stand, Brexit remains a source of a significant two‑way risk for the pound. A hard Brexit or a no deal outcome would be negative for the UK economy and the pound could drop again. On the other hand, a soft Brexit could be positive for the economy and for property markets but the resulting sterling strength may limit returns on equities, in a partial reverse of the 2016 dynamic. Investors with a low risk appetite should avoid taking a view on the negotiations and hold most of their assets in sterling.

Investors remain sensitive to geopolitical risk and it is likely we will continue to see bouts of risk aversion, with hawkish central bank rhetoric, North Korean tensions and concerns over Chinese growth the most probable sources of volatility.

However, each pause in the current equity rally has been followed swiftly by a new upward trend, as macroeconomic fundamentals (the real drivers of markets) remain supportive.

We believe the current economic cycle has some way to go. With inflation low and growth steady, the outlook for equities remains constructive, particularly while central banks opt for incremental tightening. There will be bumps along the way, but with cash losing its value on a daily basis, it still pays to stay invested.

Trevor Greetham is head of multi-asset at Royal London Asset Management